14
Mar

The sell off and the principle of diversification:

Escrito el 14 Marzo 2007 por Juan Toro en Financial Markets

The recent sell-off in the stock market has put into question a cornerstone principle of modern finance: the principle of diversification. At least this is the way that The Economist magazine saw it (the Buttonwood column). The article appearing this week points out that investors could have diversified very little as most markets plunged. Even the gold market always considered as a safe haven suffered a correction. The only portfolio that could have outweighed some losses from the market rout (at least partly) would have one holding treasuries. The article expresses a worry on the fact that this could be still an issue if we face further financial turbulence.
This view is somewhat flawed.


There are many other assets that could have played a diversifying role in the last sell-off. Holding cash one have probably the most obvious asset. But there are other assets or strategies that allow an adequate hedge within a portfolio. Investors that had bought out of the money puts on any equity index would have held a nice insurance against the market turmoil. Also buying dollars/yen forward would have done very well. This last position would have just taken the contrary position of carry trades that were being unwinded. Going long any swap spreads would have done very well in the presence of a big sell-off. Swap spreads have been trading very tight in the last two years due to the low market volatility. The ten year US spread has fluctuated around 50 basis points for a long time. Being long the fix side of the swap is a cheap insurance for any portfolio. Moreover a proper portfolio hedge requires some short selling. Just sell credit derivatives. Hence there are many ways to implement the

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